Lesson 6 of 8
Incentives and the proxy statement
A pay plan rewards whatever it measures. Read the proxy's pay tables to see whether that measure can be reached without creating any value.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A pay plan rewards whatever it measures, and earnings-per-share growth can be reached with a buyback and no real improvement in the business.
- Pay tied to return on capital or value per share is harder to manufacture with financing alone.
- The proxy states both the target and how close management came to it, so the metric chosen is checkable, not just the payout.
A pay plan is a set of instructions written in numbers, and management tends to deliver whatever the instructions actually reward. Reading the proxy for which numbers were chosen tells you what management was paid to do.
Where this year's 20 percent EPS growth came from
- If the share count had not changed$2.00
- Reported, after the buyback$2.40
Last year's EPS, net income unchanged: $2.00
What the proxy actually discloses
Item 402 of Regulation S-K governs the executive-pay disclosures in Schedule 14A, the proxy statement. The Summary Compensation Table lists each named executive's salary, bonus, and stock and options at their grant-date value. Since Item 402(v), adopted in 2022, a pay-versus-performance table sets compensation actually paid beside results. Compensation actually paid is an SEC-defined figure that marks unvested awards to their value each year. The table also carries total shareholder return, a peer group's return, net income and one measure the company picks, over up to five years, phased in across that period. First required in proxies filed in 2023, it means a reader does not have to take the compensation committee's word for whether pay tracked results.
A metric measures only what it was built to measure
Pay tied to EPS or revenue growth
- Rewards growth however it was produced.
- Reachable with a debt-funded buyback and no improvement in the business.
- Carries no charge for the capital used to reach it.
Pay tied to return on invested capital or value per share
- Rewards earning more than the capital employed costs to raise.
- A buyback leaves return on invested capital unchanged, and helps value per share only when the price paid was below value.
- Return on equity does not belong here: buybacks and borrowing raise it with no change in the business.
A metric measures only what it was built to measure. Growth can be bought with debt; a return above the cost of capital cannot.
The two are not interchangeable, and a proxy that names its performance measure is telling you which of these two games management is playing.
Read the target, then read what met it
The pay tables state a target and a payout schedule against it: for example, a bonus that pays in full at 10 percent earnings-per-share growth. That number alone is silent on how the growth arrived. The 10-K's income statement and share count, read against that target, usually show whether net income moved or whether the share count did the work instead. A target set on a metric a buyback can satisfy on its own is a weaker test of management than one set on a return above the cost of capital. The Compensation Discussion and Analysis (CD&A), just before the pay tables, names each metric, its target and why it was chosen. Read that against the target it sets.
Check yourself
A company's net income is unchanged but its share count falls after a debt-funded buyback. What happens to earnings per share?
- It falls
- It rises
- It stays exactly the same
Show the answer
Answer: B.
The same net income divided by fewer shares is a higher figure per share, even though nothing about the underlying business improved.What did Item 402(v), adopted in 2022, add to the proxy statement?
- A table setting compensation actually paid beside shareholder return, net income and a measure the company picks
- A requirement to disclose employee headcount
- A cap on total executive pay
Show the answer
Answer: A.
The pay-versus-performance table sets pay beside results over up to five years, first required in proxies filed in 2023, so the link is checkable rather than asserted.Which pay metric is harder to reach through a debt-funded buyback alone?
- Earnings per share growth
- Revenue growth
- Return on invested capital, measured against the cost of that capital
Show the answer
Answer: C.
A buyback funded with debt raises EPS without improving returns on the capital employed, so a return-based target is not satisfied by the same maneuver.Sources
- Item 402 of Regulation S-K and Schedule 14A, the proxy: executive compensation disclosure, including the pay-versus-performance table added by Item 402(v), adopted 2022, first required in proxies filed in 2023.
What this leaves out
- The bar chart and the worked example use round invented numbers so the arithmetic can be checked by hand.
- A rising earnings-per-share figure driven by a buyback is not automatically a sign of a poorly designed pay plan; a buyback made at a genuine discount to value is a legitimate use of cash even if it also helps a growth metric.
- This lesson reads the metric chosen. It does not say whether any individual executive's total pay is reasonable.
- Nothing here is advice about any security.